Self-inflicted Debt Crises

66 Pages Posted: 29 Oct 2019 Last revised: 9 Feb 2021

See all articles by Theodosios Dimopoulos

Theodosios Dimopoulos

University of Lausanne - School of Economics and Business Administration (HEC-Lausanne); Swiss Finance Institute

Norman Schuerhoff

Swiss Finance Institute - HEC Lausanne

Multiple version iconThere are 2 versions of this paper

Date Written: October 25, 2019

Abstract

Optimal resolution of debt crises requires bailouts to account for borrowers’ time-inconsistency. We show in a dynamic model of strategic default that myopic borrowers undervalue their option to default by a U-shaped error, which causes excessive leverage, imperfect consumption smoothing, underinvestment in normal times, and risk shifting in crisis times. Optimal bailouts either punish or reward myopia through smaller or larger transfers, leading to procrastinated default and protracted crises or the reverse, depending on whether financial transfers exacerbate or alleviate the borrowers’ misperception of default risk. The model shows that borrowers and lenders ultimately self-inflict debt crises through their strategic interaction, myopic distress can be cheaper to resolve than rational distress, and myopia can benefit stakeholders.

Keywords: borrower myopia, time-inconsistency, strategic default, debt crisis, bailout fund, real options

JEL Classification: H63, G01, G4, D86

Suggested Citation

Dimopoulos, Theodosios and Schuerhoff, Norman, Self-inflicted Debt Crises (October 25, 2019). Proceedings of Paris December 2019 Finance Meeting EUROFIDAI - ESSEC, Swiss Finance Institute Research Paper No. 21-11, Available at SSRN: https://ssrn.com/abstract=3475419 or http://dx.doi.org/10.2139/ssrn.3475419

Theodosios Dimopoulos (Contact Author)

University of Lausanne - School of Economics and Business Administration (HEC-Lausanne) ( email )

Unil Dorigny, Batiment Internef
Lausanne, 1015
Switzerland
0041 (0) 21 692 33 98 (Phone)

HOME PAGE: http://www.hec.unil.ch/people/tdimopoulos

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Norman Schuerhoff

Swiss Finance Institute - HEC Lausanne ( email )

Chavannes-près-Renens
Switzerland

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